The Spectrum of Evolving ETFs
The 3 types of ETFs – active, strategic beta and traditional index – can complement each other to enhance a portfolio.
TITLE: The Spectrum of Evolving ETFs
An exchange traded fund is a pooled investment vehicle. Investors can buy and sell units of an ETF on a stock exchange like individual stocks. ETFs can contain a diversified portfolio of securities designed to track a specific index or a specific portfolio.
Thanks to continuous innovation, investors and their advisors have more ETF options. There are three types: traditional index, strategic beta and active.
Traditional index [passive] ETFs are designed to track market indexes, like the S&P/TSX Composite. These ETFs are structured to mirror the composition of a specific index and they provide the lowest-cost option to get market exposure.
Index ETFs can track broad equity indexes or segments of them by investment style, such as growth, value, small- or mid-caps. For fixed income ETFs, subsets can include the broad bond market, government bonds or the corporate sector.
Strategic beta ETFs [smart beta] uses alternative index construction. They seek exposure to particular factors rather than sectors or geographies. For example, this approach can create an ETF that holds dividend-paying stocks, or ETFs that focus on the cash flows and sales of certain companies. Strategic beta ETFs can be used when an investor believes a certain sector or investment style will be overvalued or undervalued. A strategic beta ETF can provide pure exposure, instead of passive exposure to the entire market like an index ETF.
Active ETFs are the third type. Actively-managed ETFs have a portfolio manager making decisions and overseeing an underlying portfolio. These ETFs don't try to replicate an index – they track the portfolio. The manager uses fundamental, qualitative and quantitative analysis to buy and sell securities. By actively managing risk, active ETFs strive to deliver potentially higher risk-adjusted returns.
This evolving ETF spectrum lets investors use active and passive strategies to achieve their goals.
As mentioned, passive investing with traditional index ETFs simply attempts to replicate the index's performance. Here are some benefits of passive investing:
- Asset exposure: Investors receive precise, tactical exposure to certain asset classes and sectors that they might not have with other investments.
- Cost reduction: Index ETFs are considered lower-cost investments since there's no need to analyze securities in the index.
- Transparency: Investors know at all times what stocks or bonds are in an indexed investment.
Active investing aims to outperform the index benchmark. Here are a few benefits of active investing:
- Performance looks different from the benchmark - opportunistic investing by aiming to beat the index over the long run
- Risk management: Various techniques are used to try to mitigate risks created by markets, liquidity, interest rates etc.
- Professional investment management: Portfolio managers analyze companies and market conditions and make investment decisions on which stocks and bonds to buy and sell.
When it comes to portfolio construction, sophisticated investors increasingly recognize that active, strategic beta and passive investments can be useful in a portfolio. And whatever the blend is, the sum of all the exposures in a portfolio is what influences the desired outcome.
Every investment can have risks and rewards. A professional financial advisor can help you create a well-diversified portfolio tailored to your financial goals and risk tolerance. Your advisor can also monitor the portfolio and adjust it to market conditions and changing circumstances.
Ask your advisor how ETFs can help you achieve financial success.